The Allocation of Losses in Bank Resolution: A Critical Examination of the Shareholder and Creditor Burden
The winning entry of the Durham Commercial Law Journal Essay Competition
COMMERCIAL LAW
As global financial markets continue to suffer from the ripple effect of the Global Financial Crisis of 2008, which was propelled by the failure of large financial institutions, the question of who should foot the bill in the event of a bank’s failure remains largely disputed.
Whilst at first glance it would seem as though the fact that creditors and shareholders absorb losses is principally beneficial in increasing market discipline and satisfying the moral appeal to shield the innocent taxpayer, upon closer inspection, there would inevitably be a surplus of practical complications if this were to manifest in reality.
At first glance, it could be argued that this bank resolution strategy creates more benefits than complications, primarily by relieving taxpayers of the implicit financial burden they would otherwise face in the event of a bank’s failure. By jeopardising public funds whilst shielding creditors and shareholders with what is essentially a ‘Get-out-of-jail-free card’, the principal moral hierarchy which applies in this situation, in which those who directly stake a risk are more liable than bystanders who have no say in the matter, is cruelly subverted. Creditors and shareholders are often relieved from the full extent of their responsibilities while taxpayers suffer unjustly. As such, this bank resolution strategy serves as a crucial safety-net for public funds while holding those most liable in a bank’s failure to their fiscal obligation. As stated by the Financial Safety Board, this resolution strategy is targeted to ensure both creditors and shareholders absorb necessary losses before public funds are interfered with, which may serve as a way of reinforcing the responsibility of the bank’s endorsers, and preventing the public from suffering due to the bank’s self-induced precariousness. Such logic is perhaps most pertinent in the resolution of Banco Popular in 2017. Following Banco Popular’s declaration of bankruptcy in 2017, the SRB adjudicated that the shareholders had to absorb the losses, with the bank being resolved and sold to Banco Santander without using a cent of taxpayer money. Whilst the shareholders were, obviously, not entirely content with the situation (which led to the subsequent case Del Valle Ruiz and Others v Single Resolution Board (SRB)), such a successful application of the ’no taxpayer bailouts’ principle exemplifies the many civil, moral and financial benefits to this bank resolution strategy.
Furthermore, the idea that the financial burden of a bank’s failure should fall primarily on its shareholders and creditors brings myriad benefits to the banks, all their endorsers and the market itself. In other words, the idea of tying creditors and shareholders to bail-ins acts as a clear deterrent for excessive risk in bank decisions. By acknowledging the fact that the shareholders and creditors are those who financially maintain the bank, and endorse its ventures, it becomes clear that this bank resolution strategy results in increased discipline regarding the bank’s decisions, preventing fallout due to poor fiscal management. Perhaps the most applicable case study is the demise of Lehman Brothers following the 2008 financial crisis, which serves as a cautionary tale as to the damage that excessive risk exposure can cause. After having effectively put all their eggs in the basket of sub-prime mortgages, having immense financial backing by their creditors and shareholders, Lehman Brothers suffered a downfall of unforeseen magnitude. This clearly exemplifies how excessive risk, driven by a lack of accountability amongst the financiers of the bank can lead to a much wider economic collapse. More importantly, in the aftermath of the Lehman Brothers ordeal, the market experienced a much greater level of discipline due to newly imposed risk management strategies like the relevant feature of the Financial Stability Board’s Key Attributes for Effective Resolution Regimes and the EU/UK Bank Recovery and Resolution Directive/Order 2014. As such, by imposing this bank resolution strategy, bank failures can be prevented alongside any related economic fallout.
However, upon closer inspection, it becomes apparent that whilst this bank resolution strategy is cogent in speculation, it causes more complications than benefits in reality. These complications start with the risk of financial contagion that arises when creditors and shareholders are wiped out in absorbing the bank’s losses. When a bank fails and said parties are obliged to bail it out, it is likely that funds previously invested in other financial institutions would be withdrawn to liquidate sufficient capital to absorb the losses. The point at which this becomes problematic is when these external withdrawals lead to the destabilisation of other banks, causing a potentially catastrophic chain reaction. And so, whilst in theory this bank resolution strategy is morally sound, it leads to a pragmatic complication that is perhaps even worse than the initial issue of excessive exposure itself.
Moreover, as mentioned previously, the principle of bail-ins for creditors and shareholders can act as a very powerful deterrent, but possibly in the wrong way. Funding markets rely on potential endorsers’ sense of security in their positions in banks, so when such security is jeopardised by this enforced mechanism of accountability, investors may be deterred from placing financial stakes on these banks, which could lead to immense turbulence in funding markets, thus causing banks to decline in one way or another. A chief example of liability scaring off investors is the somewhat recent resolution of Credit Suisse in 2023. When it came to fruition that bondholders were wiped out as opposed to shareholders (a subversion of the traditional creditor hierarchy), AT1 bond markets collapsed, resulting in a lack of confidence in potential investors. This clearly displays the weight of liability on a certain brand of investors leads to a deficiency in endorsement opportunities for banks like what transpired following Credit Suisse’s resolution in 2023. As such, this bank resolution strategy does more harm than good in practical terms due to the external consequences that it inevitably causes.
Ultimately, the principle of holding shareholders and creditors to absorb a bank’s losses seems beneficial both in insulating the taxpayer and strengthening wider market discipline, but, in fact, both the risk of wider contagion amongst financial institutions, and the possibility of decline in funding markets because of this pressure indicate that the resultant complications carry more weight. As such, whilst moral in theory, this proposed bank resolution strategy leads to more practical complications than benefits.
Indeed, whilst this idea can be largely reconciled with pre-existing protections for depositors, there are still some outstanding complexities which could result in legal clashes between these schemes.
One of the most prevalent forms of retail insulation is the UK’s Financial Services Compensation Scheme (FSCS), which is designed to protect depositors in the event of a financial service firm’s failure to a certain extent. By offering retail depositors a bail-out capped at £85,000 per institution, the scheme manages to promote their interests whilst preventing any excessive risk on behalf of the banks who contribute to these protections that extends beyond the threshold. The fact that this protection exist is intrinsically a form of reconciliation between these two principles: creditors and shareholders can be held responsible whilst depositors are protected behind these actors. The traditional model of the creditor hierarchy suggests that creditors and shareholders stand in front of retail depositors in the event of a financial services firm’s collapse. Therefore, the code of bail-ins for creditors and shareholders innately serves as a protection for depositors, and so the two can be largely reconciled.
Despite this, there remains some outstanding nuances between both principles resulting in persistent clashes which inhibit complete reconciliation. Most significantly, the fact that protections provided to depositors is capped at only £85,000 capmeans that depositors are not sufficiently protected. When placing personal assets in a bank, depositors expect one simple quality- security. So, when such security is clearly endangered as depositors are exposed to potential losses due to this cap, public confidence in the bank will likely decline. The model of the creditor hierarchy would suggest that depositors are in no way liable for a bank’s failure, as instead of having a stake of risk, they have a position of supposed safety. This cap is therefore at odds with the idea that creditors and shareholders should absorb losses as a means of protecting depositors, as they are not covered the whole way and could very possibly be hung out to dry.
In conclusion, whilst the principle of creditors and shareholders absorbing losses is mostly coherent with protections for depositors as per the creditor hierarchy, the existence of a cap on these protections provided such depositors is somewhat inconsistent. If these two tenets of society’s financial model were to be completely reconciled, such restrictions would have to be removed, with creditors and shareholders going the full mile and shielding depositors completely.
BIBLIOGRAPHY
· https://www.fscs.org.uk/what-we-cover/banks-building-societies-credit-unions/
· Del Valle Ruíz and Others v European Commission and Single Resolution Board, Case T‑510/17, General Court (Third Chamber), Judgment of 1 June 2022, ECLI:EU:T:2022:312.
· https://eulawenforcement.com/?p=8555
· https://www.npr.org/2023/09/15/1199321274/lehman-brothers-collapse-2008-mortgages